What Should I Do With My Tax Refund? Paying Debt vs. Starting an Emergency Fund.

By Lynn Wolfbrandt
on March 17, 2017

Ah, the tax refund. That thing I used to spend before I even got it.

Maybe you’re familiar with this fun and healthy spending pattern:

“Wow, those Betsey Johnson heels are cute, and at $150, I normally couldn’t afford them. I’ll just put them on my credit card and pay my credit card off with my tax refund.”

Before I knew it, I'd have spent $2,000 of my $1,000 refund, which never worked out well for me in the long run. These days, I’m better with my money (it only took me about ten years of learning my lesson come tax time), and instead of blowing my refund before it appears, I am much more practical and interested in the long-term.

When it comes to using my tax refund today, I'm torn between paying down my debt, or building up an emergency fund. Which is better in the long run?

Option 1: Paying down debt.

You might be tempted to throw your entire refund at your loans or credit card balances. I’ve done this a few times. It feels amazing to see your debt drop down, or even disappear. You feel like you have a clean slate, and like all your financial foibles have been forgiven. You finally feel like a responsible adult who is excellent with money. Rejoice!

But this high is almost always brief. The other side of this coin is one of life’s unavoidable and crushing truths: unexpected bills happen to everyone. You’ve been there. All the sudden, your car needs new tires. You have an illness and need to see a doctor that your insurance doesn’t cover. Your sister decides to get married in Mexico and you need to buy a plane ticket. Financial curveballs come at everyone — they are part of life, year after year, no matter how much you earn, or how good you are with money.

The thing is, if you put your entire refund toward your debt, you might find yourself slipping back into debt immediately. Without an emergency fund, we are ultimately living paycheck to paycheck, and we are forced into debt to pay for life’s surprises.

So, while paying off a large chunk of debt with your tax refund might feel amazing, it can honestly be another form of instant gratification — which is maybe part of what got you into debt in the first place. It does feel better psychologically to pay your debt down, but if you don’t have a savings in place, it’s not better for you in the long run.

Option 2: Start or pad your emergency fund.

What’s better than throwing all your money at your debt? Securing an emergency fund. According to a 2017 report, nearly 60% of Americans don't have enough in savings to cover an unplanned expense of $500-$1,000. That means that any one of life’s surprises, from a car repair bill, to an emergency vet visit or that wedding you would hate to miss, has to come from an alternate source of funding — generally a credit card, which is going to cost you even more in interest over time.

An emergency fund provides you with a little bit of cushion when things go wrong, as well as a little bit of freedom when things go right. Experts suggest having a fund with up to three months’ expenses in it. You can build this fund through your tax refund, through automatic transfers each time you get paid, and through awesome apps like Digit that take little bits of money from your account to put in your savings account, without you even really noticing.

Option 3: A little bit of this, a little bit of that.

What I propose? Use a chunk of your tax refund to pay off your debt, and the rest to start or pad your emergency fund. If you’ve never had much of a savings account, I’m here to tell you that it feels surprisingly good. I didn’t have a solid one until this year, and it provides a sense of safety I didn’t know I was missing.

I still have debt to pay off, and there are some months when I use money from my savings to pay my loan bill. This way my loan gets smaller every month, but I still have a large amount in savings that allows me to pay for unexpected bills. I choose how to use or not use the money, and it makes me happy to see it sitting in my bank account every morning.

What percentage should you save, and what percentage should you use toward your debt? It depends on the types of debt you have and how you feel about your debts. Personally, I hate having credit card debt, and most experts agree that credit card debt just plum sucks. It's easy to end up giving a ton of money away as interest grows, especially if you’re just paying the minimum payment. It’s always best to pay more than the minimum each month — just play with this debt repayment calculator for a moment to see why.

With this year’s refund, I paid off the small remaining balance I had on my credit card, to avoid paying any more interest, but I didn’t throw the rest of the money at my bank loan, even though I wanted to watch the balance drop. Instead, I decided that building an emergency fund was more important to me. Plus, the interest on the bank loan is already tucked into the payments, unlike a credit card. If I paid a larger chunk of the balance now, I wouldn’t end up owing any less in the long run.

For me, the debt payment to savings ratio was about a 30/70 split. I used 30 percent to make a lump sum payment on my credit card, and tucked 70 percent into savings.

Reward your frugality!

Some experts advise you to make a fun purchase too, something to reward yourself for being responsible with (most of) your refund. This could be a nice bottle of wine, a fancy dinner out, a package of yoga classes, or anything you love that will make you feel good about using the rest of your money in a way that sets you up for future happiness and security. Just don’t buy a Tesla or pair of Jimmy Choo's to celebrate, or you’re going to end up right back where you started.

Do you have big plans for this year's tax refund? Let us know in the comments!

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